Sunday, March 12, 2017

Tax reform on the way

Tax reform is all the rage in Washington, with the focus on the “Better Way” proposed by House Speaker Paul Ryan and Ways and Means Chairman Kevin Brady. Their aim is to make “the tax code simpler, fairer and flatter, so simple that most Americans can do their taxes on a form as simple as a postcard.” So lookout, H&R Block and the armies of other tax preparers and lawyers!

Among other liberalizations, the proposal calls for reducing individual tax brackets from seven to three and dropping the top marginal rate from 39.6 percent to 33 percent. Small business would enjoy a 25 percent maximum tax rate while the corporate tax rate would fall from 35 percent to 20 percent, among the lowest among major countries. Also, a low 10 percent tax on repatriated earnings would encourage the like of Apple to bring money home.

Some argue that repatriation will boost the dollar as assets abroad are converted to greenbacks, but much of those foreign-held earnings are already in dollar-denominated investments. Others expect the money to be plowed into U.S. capital spending, but if major companies want to invest domestically and don’t have the cash at home, they can easily borrow against the collateral of their foreign-held earnings. Similarly, the boosts to stock repurchases and dividends with repatriated cash may be limited. It’s already common, as low interest rates have already encouraged corporations to borrow in order to reward stockholders.

The most novel proposal is the border-adjustment tax, which is needed to make the whole package revenue-neutral, which is attractive at a time when there are lingering concerns over earlier huge federal budget deficits. Border adjustment is a hybrid of the value-added tax used by most countries, and is essentially a tax on domestic consumption. At each stage of production, the costs of purchased goods are subtracted from the sale prices and the tax applied to the remainder. So it is a tax on the value added by labor, management expertise and profits, and so on. It’s useful in areas such as Europe, where components are produced in one country, shipped to another for sub-assembly and a third for final assembly in multi-step supply chains. This is more conducive to international trade and simpler than taxing sales of each company.

It’s also attractive because under World Trade Organization rules, VATs can be added to the cost of imports, thereby discouraging them, and rebated on exports to make them cheaper for foreign buyers. The U.S. has a heavier reliance on income and payroll taxes than other countries and they can’t be rebated on exports. Based on how much the U.S. imports and exports, there would be a net tax revenue gain of 0.6 percent of GDP. That’s $120 billion annually and more than $1 trillion in the next decade.

Here’s where the border adjustment proponents get into their fancy footwork: they assume that more-expensive U.S. imports will curb buyers’ demand and reduce the dollars needed to be paid to foreigners to buy them, while cheaper exports will enhance their appeal to foreigners and, consequently, their demand for greenbacks. So the dollar value will rise 25 percent to re-establish equilibrium by offsetting the taxes on imports and subsidies on exports. Then the exchange rate-adjusted prices of imports and exports return to where they were, except the Treasury collects a $120 billion annual windfall from foreign exporters, enough to offset tax cuts and keep the whole plan revenue neutral.

Sounds like free lunch, but there’s no such thing. If this mechanism worked, the dollar and the current-account balance, which is the broadest measure of trade, would be perfectly correlated. But they aren’t, often moving in opposite directions, as shown in the graph below. This is because the dollar is the international currency for trade and capital flows. Although 87 percent of global currency transactions involve the greenback (out of 200 percent counting both sides of every transaction), most uses of the dollar involve non-U.S. countries trading among themselves and capital transactions that have nothing to do with trade. U.S. trade makes up just 1.4 percent of the daily transactions in the dollar.

Border-adjustment fans also don’t account for the likely violent swings in U.S. imports and exports until their equilibrium is re-established. And, they aren’t considering the effects of the dollar’s leap in the cost of servicing dollar-denominated debts of emerging economies. The ongoing rush of Chinese out of the yuan and into the dollar, which has already slashed China’s foreign-currency reserves from $4 trillion in July 2014 to less than $3 trillion, would turn to an economy-wrenching flood. Credit Suisse estimated that the border adjustment would cut merchandise exports from Asia by 3 percent to 4 percent and the region’s growth by 0.5 percentage point.

Foreign governments might retaliate with shifts in income and payroll taxes to higher value added levies. No other country disallows the deductibility of import costs. The WTO would no doubt object since it regards tax exemptions on exports as illegal unless they are consumption taxes. U.S. importers, ranging from retailers who bring in cheap Chinese goods to importers of fish, are obviously upset. All want exceptions for their products, but House Republican leaders vow to permit no exceptions in imports, lest the dam breaks and the whole scheme is gutted.

The Senate and the Trump administration have yet to formally weigh in on the tax plan, and border adjustment in particular. Trump said it was very complicated, and Treasury Secretary Steven Mnuchin said it has “interesting aspects,” but “there are some concerns about what the impact may be on the dollar.” Trump has railed against the competitive devaluations of other countries’ currencies and said the buck is too robust. Nevertheless, in his Feb. 28 speech to Congress, he appeared to be sympathetic to border adjustment. Trump has noted that other countries impose tariffs and taxes on American products while the U.S. reciprocate.

Don’t expect swift action on tax reform. Many factions on both sides of the aisle will be involved and after inevitable compromises, the final bill may be quite different than the House proposal. Even Mnuchin is aware of likely delays. He said the administration is working with House and Senate Republicans to reconcile differences, with the aim of passing major legislation before Congress’s August recess. But he added, “that’s an ambitious timetable. It could slip to later in the year.” Which year?